This Is the Biggest Mistake Republicans Make About Janet Yellen

The Fed has not been following an "inflationary policy" the past few years. Just an anti-deflationary one.

Fed Chair nominee Janet Yellen meets with Republican Senator Richard Shelby (Reuters)

Republicans are stuck in 1980, but that's not far back enough for Ron Paul. He wants to drag them all the way back to 1932. And when it comes to the Fed, at least, he's already succeeded.

Now, the words "monetary policy" usually elicit a pretty predictable Pavlovian response. Yawning. Most people would rather talk about anything, really anything, other than interest rates and the money supply. (Try it sometime). That's why as recently as 2006 the Senate's Fed hearings were such a non-event. In fact, some senators were too bored to even notice they were going on. Here's what the New York Times said about Ben Bernanke's hearings at the time:

Senator George Allen of Virginia, who is considering a bid for the Republican presidential nomination in 2008, said when asked his opinion of the Bernanke nomination.

"For what?"

Told that Mr. Bernanke was up for the Fed chairman's job, Mr. Allen hedged a little, said he had not been focused on it, and wondered aloud when the hearings would be. Told that the Senate Banking Committee hearings had concluded in November, the senator responded: "You mean I missed them all? I paid no attention to them."

He was not the only one. Senator John McCain, Republican of Arizona, regarded by some as a front-runner in 2008, also had no idea that the Bernanke hearings had come and gone.

How quaint. Today, of course, pretty much every senator knows who Fed Chair nominee Janet Yellen is. And pretty much every Republican senator will at least publicly oppose her. Because ... inflation? It's a bizarre criticism at a time when inflation is still near historic lows and unemployment is still far too high. But it's the bizarre criticism that Republicans have settled on. It's why, as Paul Krugman points out, Senator Pat Roberts has said he won't vote to confirm Yellen:

Vice Chair Yellen will continue the destructive and inflationary policy of pouring billions of newly printed money every month into our economy, and artificially holding interest rates to near zero. This policy has been in place far too long.

But what inflationary policy is he talking about? Zero interest rates and bond-buying haven't sparked high inflation. They've been a response to low inflation, just 1.2 percent in September. You can see that in the chart below of core PCE inflation (blue), the Fed funds rate (red), and quantitative easing (gray shading) going back to 1960. Rates have gone after inflation has gone up, and rates have gone down when inflation after gone down. Or, as Milton Friedman famously put it, low interest rates are generally a sign that money has been tight, not that it's easy.

This is a crucial point. You can't tell how tight or loose monetary policy is just from how high or low interest rates are. The only way to tell is to look at how the economy is doing. Take the 1970s. Interest rates were actually pretty high, but there was still an inflationary spiral—was that "tight" money? Or take the 1930s. Interest rates were zero, but the economy was still in a deflationary death spiral—was that "loose" money. In both cases, the answer must be no, otherwise the terms "tight" and "loose" money would have no meaning whatsoever. Instead, we should say money is tight when inflation is lower than we'd like, and it's loose when inflation is higher than we'd like.

That used to be the foundation of conservative macroeconomics. See, Friedman argued that the Great Depression wasn't a failure of capitalism. It was a failure of central banking. Because the Fed itself fell for the fallacy that low rates equal easy money, it didn't even really try to revive the economy; in fact, it made things worse in 1931 by raising rates to defend the gold standard. If instead the Fed had bought bonds to fight deflation, the depression, the depression wouldn't have been so great—or so the story went. In other words, monetary stimulus could make fiscal stimulus unnecessary.

But Republicans have forgotten this. They've come around to another way of looking at the Fed—Ron Paul's way. Paul thinks that central banking inevitably creates booms and busts, because it's just central planning for interest rates. And that any kind of money-printing inevitably turns into inflation. Now, so-called Austrian economics did do a good job "predicting" the housing boom and bust. But that's because it always predicts booms and busts. Nonetheless, that's been enough for it to spread from Ron Paul to Republicans more broadly—and that despite its terrible track record the past few years.

Lately, it's predicted an even bigger bust and Zimbabwe-style hyperinflation. These things have not happened. The opposite, actually. Markets have kept going up, and inflation has kept going down. So Republicans have denied this . Some, like Senator Tom Coburn, have said that inflation must really be higher (except when it's really lower). Others say that inflation isn't here yet, but will be eventually. In either case, it's a constant fear of inflation, imaginary or hypothetical, despite persistently low inflation and high unemployment.

They need a new Milton Friedman to lead them out of this monetary Dark Age.